Derivatives pricing under bilateral counterparty risk

Peter Carr, Samim Ghamami

Research output: Contribution to journalArticle

Abstract

We consider risk-neutral valuation of a contingent claim under bilateral counterparty risk using the well-known reduced-form approach. Probabilistic valuation formulas derived under this framework cannot be used for practical pricing due to their recursive path dependencies. By imposing restrictions on the dynamics of the risk-free rate and stochastic intensities of counterparties’ default times, we develop path-independent probabilistic valuation formulas that have closed-form solutions or can lead to computationally efficient pricing schemes. Our framework also incorporates wrong-way risk (WWR). Advancing the work of Ghamami and Goldberg, we derive calibrationimplied formulas that enable us to compare derivatives values in the presence and absence of WWR.We illustrate that derivatives values under WWR need not be less than derivatives values in the absence ofWWR.Asufficient condition under which this inequality holds is when the price process follows a semimartingale with independent increments.

Original languageEnglish (US)
Pages (from-to)77-107
Number of pages31
JournalJournal of Risk
Volume20
Issue number1
DOIs
StatePublished - Oct 1 2017

Fingerprint

Bilateral
Counterparty risk
Derivative pricing
Derivatives
Pricing
Path dependency
Risk-neutral valuation
Semimartingale
Contingent claims
Reduced form
Closed-form solution
Risk-free rate

Keywords

  • Asset pricing
  • Counterparty risk
  • Credit value adjustment (CVA)
  • Reduced-form modeling
  • Wrong-way risk (WWR)

ASJC Scopus subject areas

  • Finance
  • Strategy and Management

Cite this

Derivatives pricing under bilateral counterparty risk. / Carr, Peter; Ghamami, Samim.

In: Journal of Risk, Vol. 20, No. 1, 01.10.2017, p. 77-107.

Research output: Contribution to journalArticle

Carr, Peter ; Ghamami, Samim. / Derivatives pricing under bilateral counterparty risk. In: Journal of Risk. 2017 ; Vol. 20, No. 1. pp. 77-107.
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